Month: January 2013

I’ll be honest, when I originally posted about SNL back in 2011, I thought I’d found a cheap company with a stable business that wasn’t set to grow much faster than the economy. Back then, it was a $19m market cap minnow, selling for 9.2 times earnings. Since then market cap has more than tripled, to $53m, and earnings have kept a reasonable pace, with a P/E multiple of 13.39. Over the past 2 months alone it has rocketed from the $1.20 range up to $1.60!

So today management released preliminary HY13 figures. NPAT of $2.08m represents an increase of around 17% against PCP, with a half year dividend of 3.5c. I’ve already sold down half my holdings, and my 1 year capital gains discount applies at the end of February. I’m still sitting on a 75% profit on my most recently bought parcel, so if share prices are still at current levels in a month’s time I will take profits. Much of SNL’s growth has been from Central Queensland mining, and if commodity prices fall it could lead to reduced sales.

I have been a fan of Nassim Taleb for around 5 years, having started out with Black Swan in 2008. Taleb’s traditional work has been focused around robustness, making systems less vulnerable (fragile) to Black Swan events (seeing as they can’t be predicted). Antifragility extends this thinking further, identifying ways to make systems benefit from shocks and stressors. Our own bodies benefit from minor stressors, a biological response known as Hormesis. To use weightlifting as an example, when you deadlift 100kg, your body sustains some damage, and then responds by not just repairing the muscle, but repairing it in a way that it is now capable of deadlifting 105kg.

One of the challenges in reviewing Taleb’s work is that he carefully writes his books so they can not be easily summarised, he writes his books for the reader, not for the reviewer. I know several people who have given up partway through one of his books because of his idiosyncratic writing style, but his ideas are worth taking the time to understand. So rather than try to summarise the book I’m going to outline the key concepts I drew from the book and finish by explaining how I’ve applied the concepts of antifragility on my own portfolio (and life) strategy. I include the concept of robustness in my thinking already so I’m not going to talk much about that here.

Antifragility as optionality:

Options (in the financial sense) have an asymmetric payoff. If you are writing put/call options, you are accepting a small, certain payoff from the person taking the option. So you do not want large volatility. A person who buys an option wants volatility, so that their option increases in value. It doesn’t cost a lot to buy a deep out-of-the money option (eg AUD/YEN calls that exercise at 104 Yen = $1AUD. At time of writing the Yen is at 95.27). So the option is cheap because such a large move in the next 6 months is unlikely. But if a disaster happens and the Yen devalues to 120 to the AUD, suddenly you have a massive payoff.

Optionality can also be characterised outside finance. It’s the analogy of planting seeds, it doesn’t matter how unlikely the payoff is, all that matters is that you have a lot of them, and some of them will pay off. You are assuming that the expected value of the aggregate payoffs is higher than the cost of planting these seeds, something I’m generally confident in if the option is cheap because of 2 reasons:

The more unlikely an event is, the less accurate an estimate of its probability will be

People in general underestimate the value of extremely cheap options (like being polite)

It’s human nature to take a guaranteed small payoff, while ignoring the hidden risks, analogous to picking up coins in front of a steamroller. You steadily profit for years, and then suddenly, your cumulative returns are wiped out in a matter of minutes. Almost every single transaction has some asymmetry to the payoff, and the golden rule is that if you aren’t sure who the sucker is in a transaction, it’s you.

Barbell Strategy

Taleb has spoken on the Barbell strategy in his previous books, albeit more through the traditional lens of what he refers to as “vulgar finance”. A barbell portfolio consists of 90% cash with 10% spread across a large amount of cheap options, so your downside is limited to a 10% loss against the possibility of unlimited upside. During times of low volatility you are likely to break even or lose a little, so you are chasing large volatility so that your options pay off hugely. This is an antifragile portfolio.

The idea is extended in antifragility talking about career choices. If you want to become a novelist, better to choose a boring, stable job such as civil servant during the day, and then write at night, rather than become a journalist and write as a career. Albert Einstein came up with his theory of relativity while working as a patent clerk.

The barbell can also be applied to health. It is better to drink liberally 5 days a week and then totally abstain from alcohol for 2 days, than to drink a smaller total amount of alcohol spread evenly across 7 days a week. It is better to lift 100kg once, than to lift 10kg 10 times. Avoid clinical evenness and instead regularly surprise any system you rely on, so that it becomes hardened against stressors and stronger as a result.

Via Negativa

The idea of Via Negativa is that it is better to remove something harmful from a system than to try to add something positive. I haven’t watched the news in over year, because 99% of it is complete crap, and a waste of brain cycles. If something important happens, I’ll surely hear about it from somebody else. By removing news from my life, it has improved my life and my ability to process information because I’m not distracted by the noise.

When I’m analysing a stock to invest in, my first step is to try and qualify out (find a reason not to invest) because then I can safely move on without wasting time and effort trying to justify how some perceived positive outweighs a dealbreaker negative. More information doesn’t necessarily lead to better decisions, and your time is better off identifying the 2 or 3 key factors that will influence an outcome, rather than worry about 20 others that are of not real importance, and just serve as red herrings.

It is human nature to intervene where doing nothing is probably better, because it feels more productive to interfere than allow things to run their course. A frequent application of this concept applies to healthcare, where Taleb cites as an example, an empirical study on hypertension treatment. The study confirms that treatment of hypertension only improves the patient’s condition when their systolic blood pressure is above 170, while treatment for those below 170 receive little benefit but are still exposed to the side effects.

This is just an example but Taleb cites many others in his book, which can be boiled down to the general rule of thumb, to “avoid intervention unless the condition is serious, and if it isn’t rely on Mother Nature who has a better track record than new treatments”. Another example is with smoking, where not smoking has saved more lives than every medical breakthrough since penicillin. So if you want to live longer, health foods and antioxidants are going to have a minimal impact, just avoid smoking (and occasionally starve yourself).

How I have applied the antifragility concept to my own life

Diet & Health

Rather than eat moderately healthy all 7 days per week, I fast on Fridays until dinner, and then pig out on Friday night and Saturday during the day. I have 2 alcohol-free days per week. I was never big on vitamins but have just focused on eating reasonably healthy with the odd fast and odd lapse. I don’t smoke, and exercise moderately. There’s not much point focusing on optimising my health much further because I’m already 90% of the way there. In fact, smoking outweighs all other health habits so heavily that any smoker who gives health advice can rightly be called an idiot, to their face.

Portfolio

Given the upcoming volatility I’m about to flip my portfolio into mostly cash, including my super, and just sit on it until some good investment opportunities arise. I’ve found a few already (mostly mining focused) where I’m making small investments $1000-$2000 to capture big upside. I’m not looking to make 20%, these are 10 baggers. Some will go to zero so it’s not a core component of my portfolio.

I’m also dipping my toe in the water with derivatives. Right now it’s purely vanilla calls/puts, on currency pairs. I can take an option on an EUR/USD contract for around $40 which is 10,000 units for 180 days. Sure they are deep out of the money but they don’t have to move much for me to cash in big, and that’s the idea. So I am long volatility. It’s a pretty pedestrian derivative portfolio but I’m happy to take things slowly here.

Conclusion

Because I have low living expenses, low debt, and a strong professional network I’m already pretty robust, so capturing some antifragility is something I’d only consider after getting these things in place. Antifragility is minor in comparison to robustness, because not being robust opens you to getting screwed, while not being antifragile only means you miss out on capturing the upside.

I recently took a position in a firm I didn’t even know was listed; higher-end alternative to Google Maps, Australian company Nearmap (NEA). I first became aware of Nearmap when they mapped Brisbane during the 2011 floods, letting users see a before and after of key areas. By regularly photographing at higher resolutions than Google Maps, there are significant applications within a number of industries, such as Government, Construction, and any other organisation which requires regularly updated, high resolution maps.

An example of Nearmap’s image quality

Acquired by intellectual property firm Ipernica, the Nearmap product is now core business for the firm who has divested their IP interests and renamed the company to Nearmap. Originally a free service, at the end of December Nearmap has switched to a paywall, and turned cashflow positive within a month.

While at a market cap of $22m, Nearmap is pretty cheap for a quality product in what is a winner-take-all market, but it breaks a lot of traditional value investing rules. No long-term history of earnings, no dividend, etc. Admittedly I’m breaking a few rules here, but I also understand the carrier business pretty well, having successfully capitalised on the meteoric rise in earnings (and share price) of firms such as BigAir and Amcom. Nearmap is similar to telecommunications firms because they provide access to an asset in exchange for a regular subscription. Once you’ve covered your startup costs and opex, your incremental cost to add new customers is close to zero, leading to regular and profitable cashflow.

While quarterly cashflow is still forecast to be lumpy, Nearmap have great customer re-sign rates, and given the CEO was anticipating to go cashflow positive by the end of 2013, to cover costs a year early is great news and bodes well for the future of the business. The CEO Simon Crowther is also quite active on Twitter @NearmapCEO. It’s hilarious to see the outrage from users who were never going to pay for it razzing the CEO for monetizing a product that is evidently of value to the Enterprise.

Nearmap could easily get hyped due to its profile to regular investors, and if the price suddenly goes parabolic I’m going to flip my shares for a quick profit, otherwise hold on and hopefully the cashflows will steadily increase. Not my usual value approach, but in my view quite cheap for a quality product at a good price, with loads of upside and (it would seem at this stage) not a lot of downside.

After a year’s patience with HNG I’ve decided to sever my relationship with the holding and my book is already thanking me for it. It had a big margin of safety which was unfortunately eroded by multiple businesses losing money, particularly Biante. If the business had stayed profitable, I could have justified maintaining my holding, but with the group currently booking losses, I’ve decided to exit my position to tally up the lessons learned.

This is not before taking a 60% haircut from what was a fairly large position. Looking back at what I could have done better, the main thing I could have done to improve the final outcome would have been to take a smaller position so it would have had a smaller impact on my portfolio.

The original purchase had a decent margin of safety, but with the businesses losing money (and only a few small pieces of good news such as from the Mountcastle brand) it was time to SUMO (Shut Up and Move On).

This is the only adjective I would use to describe the current economies of the developed world. I have set out my reasoning below, with what I am planning to do to protect my assets.

While it is already outlined in the “about” section, I am not a financial advisor and nothing on my website constitutes financial advice. If you copy something I am doing without doing your own research first, you are an idiot.

Regional overview:

United States

The US Economy has passed the point of no return and will have no choice but to cut the budget in half or hyperinflate their currency, either of which will cause a depression. Bernanke’s successive rounds of QE have been keeping a lid on things but eventually the pack of cards is coming down. The US Dollar will tank, as will their bonds and alternative currencies will be sourced for international trade. If this happens I am anticipating a period of chaos as currency markets attempt to find a new equilibrium.

GDP forecasts for 2013 have already been revised down, not that economic forecasters have ever been able to predict the future accurately. It’s telling that most of the commentary still calls for growth to slow as the worst case scenario. Try hyperinflation/depression in the US where GDP falls 10% or more YoY and takes the rest of the world down with them.

Eurozone

Tax-happy socialists are beginning to realise that bleeding the super-rich dry will just encourage them to leave for lower-taxation countries, such as Gerard Depardieu’s recent move from France to Russia. Expect more of this to happen as frustrated entrepreneurs quit the US and Europe for business-friendly countries like Singapore and Hong Kong.

At some point, these guys are going to have to balance the books. In all honesty, I think the Spanish and French budgets in their current state will end up next December with a greater deficit than currently forecast.

Japan

While the fertility rate has bounced from a low of 1.26 in 2006 to 1.39 in 2011, the death rate is accelerating, from 6.2 per in 1980 to 9.9 in 2011. Population change is now -1.6 per 1000. Beleaguered by expensive exports in the 2000s, the Yen has finally begun falling yet Japan still has a Debt/GDP of 230%!

Oddly enough I see life in Japan to be least affected of the 3 regions. A yen devaluation would help exports and cost of living is already quite low thanks to low wages. There are still plenty of question marks – they have changed Prime Ministers 7 times since 2006, tensions with China are increasing, and they have posted regular trade deficits over the past 2 years.

The real challenge in Japan is they are in uncharted territory for almost every metric. GDP flat, debt massive, 0.1% interest rates, stubbornly strong Yen, it’s all too challenging for me to focus a lot of effort on.

China

Part of China’s success has been the undervaluation of the Yuan, thanks to their central bank buying treasury bonds. If this comes to an end it will weaken China’s manufacturing strength.

Additionally, China is just too much of a black box. Rather than try to predict what is going to happen, I am going to try and avoid it, and focus on the “surer things”: US and Europe.

Conclusion:

After a massive debt binge, the chickens are coming home to roost for the global economy, and anybody who gambles on things improving is likely to face big losses to their asset portfolio. It’s not a doomsday scenario, things just need to reset, but those who are vulnerable to economic shocks are going to be in for a tough time.

While there might be opportunities in China and Japan, they are ones I am happy to leave on the table, as the bond devaluation/currency hyperinflation scenarios are much easier to work with. Of course, living in Australia there will be domestic opportunities as well.

What I am planning to do

If I was living in the US or Europe I probably would have already moved somewhere else. Fortunately Australia’s monetary policy isn’t too bad, debt is only 23% of GDP, and with most households up to their eyeballs in mortgage debt, lower interest rates will put more money in most people’s pockets. I have been unwinding my book down to a couple of shares like BGL (which I have already reduced by 25% and plan to reduce further) , and am aggressively paying down my mortgage due to its untaxed, risk-free return. In general I think equities are a sucker play in 2013 – the ASX will likely bumble along between 4000 and 5000, but if the world falls apart we are headed south big-time. I don’t want to get an average return with the risk of losing half my capital. I’m also planning to switch my super from shares to cash.

I recently bought a couple of Panerai watches 2nd hand, which should hold their value if not increase, and my living expenses are extremely low. If the Yen crashes, I will consider moving to Japan (My wife is Japanese). You can buy a house in the Tokyo suburbs for well under $200k at current FX, and 10 year fixed mortgage rates are 1.6%.

This makes me fairly robust, but I want my portfolio to be Antifragile. I read Taleb’s latest book over the holidays and will be writing a post on it soon.

I plan to buy options to expose myself to upside if my projections happen to occur. Given the chaos that I think will ensue simply shorting or going long (especially on margin) exposes me to big swings and sleepless nights. Buying options will expose me to the bigger upside of transactions with an asymmetric payoff, and these are the positions I am currently investigating:

US bonds: Short

US Dollar: Short

French, Spanish bonds: Short

Copper: Short

ASX: Short

In the meantime, none of this is going to distract me from enjoying life.

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The purpose of this page is to share what I am doing, not to provide advice. Always do your own research.